How Might Health Insurers Respond to Medical Loss Ratio Regulation?

As Washington continues to micro-manage various industries via royal decree, it is becoming increasingly evident that Congress is afflicted by some combination of the following conditions:

Ignorance of industry specific business models

An inability to read financial statements

Willful disregard of #s 1 and 2

Delusions of grandeur

Now, I will readily admit that the near collapse of the financial system is evidence in and of itself that the pre-crisis regulatory framework was flawed. However, the solution to ineffective regulation is not the passing of more ineffective regulation. In other words, Congress seems to assume that capitalism's regulatory guard rails simply weren't strong enough, as opposed to questioning whether those rails were even in the proper location.The latest Congressional foray into the ineffective regulation of business is contained within H.R. 3962 (the Health Care bill). Apparently, the likes of Harry Reid and Maxine Waters have secretly been working towards a masters degree in actuarial statistics, and have subsequently determined that the health insurance industry can make coverage more affordable by throwing all actuarial assumptions out the window. This strange brand of ill-informed meddling has culminated in Section 102 of H.R. 3962, in the form of a mandate that health insurer's medical loss ratio never dip below 85%. The medical loss ratio is calculated as medical benefits paid divided by premiums received.

Now, all questions regarding the ability of Congress to properly determine a reasonable medical loss ratio aside, I'll turn to an analysis of where this ratio has trended over time. Below is a chart comparing the medical loss ratios of United HealthCare (NYSE:UNH), Aetna (NYSE:AET), Wellpoint (WLP), Humana (NYSE:HUM) and Coventry Health Care (CVH). Data is based on the 9 most recently reported quarterly results for the above mentioned firms:Click to enlarge

The evidence above would suggest that the health insurance industry's major players are already operating at a medical loss ratio of between 80-85%. So why make a point of regulating this metric? I certainly don't purport to know the absolute truth on this one, but one could theorize that Congress intends to start at 85%, and slowly creep up into the 90s. Nevertheless, we can assume that these firms will need to take steps towards putting themselves comfortably within the 85% medical loss ratio mandate. The most likely compliance scenario will involve management's assessment of operating expenses. A little "trimming the fat" analysis if you will. To get an idea of where operating expenses stand relative to premiums at these large firms, I've prepared the analysis below.

As you can see above, medical costs and operating expenses combined have come close to - or in most cases exceeded - premiums received by the major health insurance companies. Therefore, health insurance firms are not able to turn a profit from premium revenue alone. Profitability, it seems, is achieved by two other sources of revenue: fees and investment income. Because investment income is unreliable in many circumstances, and the premiums charged to individuals will henceforth be regulated in arbitrary fashion, I can only see two ways that health insurers will respond:

Reduce operating expense via layoffs and off-shoring where possible

Increasing fees that Congress didn't remember to regulate

If I could make a recommendation to the industry, it would be to arbitrarily "invent" new fees. Maybe introduce another stage to the application process that would require payment of additional fees. To introduce a little bit of irony to the situation, the industry could pretend that it now faces burdensome ratio compliance costs, and must assess a few cents worth of compliance fee upon every claim. Remember: Focus on the Fees.